The infrastructure fund industry, like many other alternative investment sectors, is currently characterized by high interest rates and low transaction volumes. Despite these challenges, the industry demonstrates resilience, particularly in renewable energy, fiber networks and data centers, supported by quite robust valuations. Given this context, it is crucial to examine how the new Pillar II regulations will affect this fund sector.
Effective for fiscal years starting after 31 December 2023, the Global Minimum Tax Directive, also known as Pillar II, will impact multinational groups with consolidated revenues of at least €750 million. The goal of Pillar II is to ensure that multinational groups pay a minimum tax of 15% in each jurisdiction where they operate. The top-up tax, calculated as the difference between the actual effective tax rate and 15%, is typically due by the ultimate parent entity unless the low-tax jurisdiction implements a qualified domestic minimum top-up tax. Infrastructure groups may fall under the scope of Pillar II if they meet the consolidated revenue threshold. Infrastructure investment funds must consider Pillar II rules, even without fund-level consolidation, if:
- The target group consolidates,
- An investor has a controlling interest and consolidates the fund in their financial statements, or
- The fund co-invests with a partner within Pillar II’s scope, consolidating their co-investment vehicle in the partner’s financial statements
Fund managers should review their current structures to identify if their funds or underlying entities are in scope of Pillar II. If applicable, a top-up tax could impact projected returns, necessitating a review of financial models.
Managing consolidation, compliance, and fund documentation under Pillar II
The implementation of Pillar II involves several layers of compliance and strategic planning. Infrastructure funds must navigate the complexities associated with seed capital and investor ownership percentages, which could inadvertently lead to a controlling stake, triggering additional requirements. Pillar II can be triggered when there is a mandatory obligation to prepare line-by-line consolidated financial statements, at the level of a fund or at the level of a controlling party of the fund (as well as in certain cases of co-investments accounted under the equity method where one of the partners has an ownership interest of 50% of more. To assess whether a Luxembourg fund parent is required by law to prepare consolidated financial statements, one must start with the consolidation provisions from the 1915 law on commercial companies, section XVII ”Consolidated Account” (the “Commercial Company Law”), and determine how they apply to an entity; and continue with the provisions laid down in the product-specific laws (SIF, SICAR, RAIF, UCI laws). In instances of deviation from the Commercial Company Law, the product-specific laws should take precedence.
As an outcome of this assessment, Luxembourg parent entities organized as SCSps, SIFs, SICARs, RAIFs and UCI Part II SICAVs, reporting under Luxgaap, are exempt from consolidation under Luxembourg laws. However, if any of those opt for IFRS, only small-size groups and subgroups would benefit from a consolidation exemption, and investment entities, as defined under IFRS 10, would measure their investments at fair value rather than presenting line-by-line consolidation. In addition, any other AIF, or any unregulated commercial companies organized as an SA, SE, Sarl, SCA, SAS and certain SCSs, are required under Luxembourg laws, to prepare consolidated accounts regardless of the gaap chosen, unless they can benefit from an exemption (again, only small-size groups and subgroups would benefit from a consolidation exemption), the PE exemption for Luxgaap or the investment entity exception under IFRS 10.
In situations where fund statutory accounts are in Luxgaap and, in addition, consolidated accounts are prepared under IFRS for investor purposes, it is crucial to determine whether this constitutes mandatory consolidation or not. If IFRS consolidated accounts are prepared alongside statutory Luxgaap accounts without a legal requirement to prepare consolidated accounts under Luxembourg laws and without these being published in the Commercial Register, these consolidated accounts would be seen as non-mandatory and therefore the fund would not be considered an ultimate parent entity (UPE). Special situations, such as entities not subject to mandatory consolidation but filing consolidated financial statements as a unique set of financial statements, or SCSps, not subject to any filing requirements but presenting consolidated statements to investors, could lead to the fund being seen as a UPE and would have to be analyzed in more detail. Finally note that contractual consolidation should generally also not lead to being in scope for Pillar II.
As mentioned above, Pillar II can be triggered by a controlling party in scope of Pillar II itself. Fund managers need to understand whether any investor would control the fund and if it does, would prepare a consolidation on a line-by-line basis. Understanding whether the fund is or is not in scope of Pillar II, and if so, whether the fund would be liable for the top-up tax; remains the responsibility of the fund manager. Getting timely and proper access to information needed for Pillar II is therefore crucial. Pillar II considerations and appropriate questions should be added to the investor due diligence process. Going forward, if an investor could be in scope of Pillar II, it may be considered to limit its investment percentage in the fund so that it does not constitute a controlling stake and below 50% so that the investor is not regarded as a JV partner. Alternatively, the fund documentation could contain provisions that protect the fund and other investors from Pillar II effects, such as an indemnity mechanism for any additional taxes paid by the fund structure due to Pillar II or ensuring that a controlling investor (or an investor treated as a JV partner) in scope of Pillar II cannot elect any fund entity as paying or filing entities for Pillar II returns.
Effects of Pillar II on fund valuation
The OECD Pillar II rules, designed to ensure multinational enterprises (MNEs) contribute their fair share of taxes, pose certain challenges for investment funds. These funds, often intertwined with MNEs through diversified portfolios, co-investments, or control structures, must adapt their valuation strategies to navigate this shifting tax landscape. Funds holding shares in MNEs must reassess their valuations in case of increased tax liabilities. These liabilities are likely to reduce after-tax profits and subsequently market values, requiring adjustments to net asset value (NAV) models. Regular reviews and updates to these models are essential to ensure compliance and precision in valuation. In fact, in May 2023, the ESMA's findings on the Common Supervisory Action (CSA) led the CSSF and other authorities to recommend annual independent reviews of valuation models to ensure fair valuations, also considering the tax implications of Pillar II (due to the fact that a group can be in scope of Pillar II for one year and out in the next depending on the whether its consolidated revenues are above or below €750 million). EY frequently integrates reviews of such tax considerations in their independent model reviews, which enables AIFMs to kill two birds with one stone.
Companies operating in infrastructure often benefit from legitimate tax credits, subsidies and incentives due to the nature of their activities. This could lead them to be considered as low-taxed and subject to a top-up tax. It is important to assess whether the tax credits and subsidies are in line with the Pillar II taxable income computation.
Infrastructure investment funds with stakes in companies operating in low-tax jurisdictions or which benefit from local tax credits, subsidies and incentives will need to consider Pillar II impacts and if necessary reevaluate their strategies, potentially leading to portfolio rebalancing. Top-up taxes and compliance costs could impact the overall expected fund performance and valuation. Furthermore, funds relying on dividend income must consider the potential decrease in distributable profits from MNEs facing higher tax bills. This reduction in dividends necessitates adjustments in valuation models, particularly for income-focused funds, making accurate financial forecasting critical for maintaining performance.
The global minimum tax rate may also shift capital flows across borders as investment incentives in certain jurisdictions change. Investment funds must closely monitor these shifts to understand their effects on the valuation of international holdings. The reallocation of capital could alter growth prospects and risk profiles, requiring agile adjustments to investment strategies. Additionally, Pillar II’s emphasis on increased transparency and detailed tax reporting will likely raise compliance costs for investment funds. These operational expenses must be factored into valuation models, and ensuring portfolio companies adhere to new regulations will necessitate enhanced due diligence and robust governance frameworks. As investor perceptions and risk assessments evolve in response to Pillar II, effective communication about the new tax rules' impact on fund performance and valuation will be crucial for maintaining investor confidence amidst these regulatory changes.